Pros and Cons of FOREX Arbitrage

Using triangular or transitivity arbitrage strategies on the FOREX market has one very salient advantage: predetermined profits can be realized if the trades execute smoothly. Unfortunately, the disadvantages of this strategy are numerous:

Higher transaction costs. The trader must pay the bid-ask spreads on three separate trades.

Higher margin requirements. Roughly three times the margin is necessary to execute the arbitrage strategy and odd-lot trading may be required for the small capital investor.

Precision timing is required.

Arbitrage opportunities are usually short-lived.

Multiple dimensions. The trader must thoroughly understand the arbitrage mechanism before determining which currency pairs to buy and which to sell. Each arbitrage package consists of two buys and one sell or one buy and two sells. Miscalculating any one of the three trades can cause disaster.

Advanced monitoring techniques are usually required. This means calculating the preceding analysis on several pairs simultaneously in real time and will involve a software program that continually analyzes streaming quotes. It is possible to perform these tasks manually, but the trader must have a high tolerance for tedium.

I must also mention that in the preceding examples, I intentionally simplified calculations by using only the bid price throughout. When executing an actual arbitrage trade, the investor must supply both bid and ask rate where applicable.

If you take a snapshot of all the major pair cross-rates at a given time and use transitivity to calculate from one end to the other, you will find the whole is not the same as the sum of the parts. The trick is catching those anomalies as they stream along in real time. Think low latency -- very low latency.

By Michael Duane Archer

Michael Duane Archer has been an active futures and FOREX trader for more than 35 years. He has worked in various advisory capacities, notably as a commodity trading advisor, registered SEC investment advisor, and branch manager for Heinold of Hawaii. He currently trades FOREX and futures and is involved in several technical analysis research projects.